“The implications of this boom and its possible reversal in coming years stands as a serious issue for economic policy makers,” Shiller said on Friday.

He said that 50 percent declines in the worth of some cities’ homes wouldn’t be unprecedented. Prices in London and Los Angeles fell by almost that amount from the late 1980s to mid-1990s.

US house values, in constant or real dollar terms, rose 86 percent from the end of 1996 to early 2006, the peak of the most recent housing boom, Shiller said. Economic factors such as rents and construction costs don’t appear to explain the jump in prices, suggesting “speculative thinking” and a “boom psychology” was at work. “Extravagant” expectations for future price increases since the late 1990s fueled the bubble, Shiller said.

Harvard University Professor Martin Feldstein, who is a member of a group that calls the timing of recessions, said that the housing contraction threatens a broader recession, and the Federal Reserve should lower interest rates.

"The inability of credit markets to function adequately will weaken the overall economy over the coming months. And even when the credit market crisis has passed, the wider credit spreads and increased risk aversion will be a damper on future economic activity.

Even with the best of policies to increase liquidity, future aggregate demand is likely to be depressed by weak housing construction, depressed consumer spending and the impaired credit markets. Lower interest rates now would help by stimulating the demand for housing, autos and other consumer durables, by encouraging a more competitive dollar to stimulate increased net exports, by raising share prices that increased both business investment and consumer spending, and by freeing up spendable cash for homeowners with adjustable rate mortgages," Feldstein told attendees at the Jackson Hole Symposium on Saturday.

``The economy could suffer a very serious downturn,'' Feldstein said. ``A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome.''

Feldstein said that Shiller's analysis began with the striking fact that national indexes of real house prices and real rents moved together until 2000 and that real house prices then surged to a level 80 percent higher than equivalent rents, driven in part by a widespread popular belief that houses were an irresistible investment opportunity. How else could an average American family buy an asset appreciating at 9 percent a year , with 80 percent of that investment financed by a mortgage with a tax deductible interest rate of 6 percent, implying an annual rate of return on the initial equity of more than 25 percent?

"But at a certain point home owners recognized that house prices – really the price of land – wouldn't keep rising and may decline. That fall has now begun, with a 3.4 percent decline in the past 12 months and an estimated 9 percent annual rate of decline in the most recent month for which data are available. The decline in house prices accelerates sales and slows home buying, causing a rise in the inventory of unsold homes and a decision by home builders to slow the rate of construction. Home building has now collapsed, down 20 percent from a year ago, to the lowest level in a decade.

Ed Leamer explained that such declines in housing construction were a precursor to 8 of the past 10 recessions. Moreover, major falls in home building were followed by a recession in every case except when the Korean and Vietnam wars provided an offsetting stimulus," Feldstein said.

"Why did home prices surge in the past 5 years?" Feldstein asked. 

"While a frenzy of irrational house price expectations may have contributed, there were also fundamental reasons. Credit became both cheap and relatively easy to obtain. When the Fed worried about deflation it cut the Fed funds rate to one percent in 2003 and promised that it would rise only very slowly. That caused medium term rates to fall, inducing a drop in mortgage rates and a widespread promotion of mortgages with very low temporary teaser rates," he said.

Feldstein said that the Fed should cut the federal funds rate to 4.25 percent from 5.25 percent even though such a move would likely stoke inflation. 

Lowering interest rates may result in a ``stronger economy with higher inflation than the Fed desires,'' a scenario that Feldstein described as the ``lesser of two evils.''

"If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it succeeds in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability," Feldstein concluded.

NOTE

Martin Feldstein is the George F. Baker Professor of Economics at Harvard University and President and CEO of the National Bureau of Economic Research (NBER). From 1982 through 1984, Martin Feldstein was Chairman of the Council of Economic Advisers and President Reagan's chief economic adviser. He served as President of the American Economic Association in 2004. In 2006, President Bush appointed him to be a member of the President's Foreign Intelligence Advisory Board. He is a member of the Business Cycle Dating Committee of the NBER, which like Harvard is located in Cambridge, Massachusetts

Robert J. Shiller is the Stanley B. Resor Professor of Economics, Department of Economics and Cowles Foundation for Research in Economics, Yale University